This paper provides business owners with a practical guide to securing bank loans by explaining the four primary factors lenders evaluate: credit history, collateral availability, business cash flow cycles, and debt-to-net-worth ratios. It outlines how applicants can strengthen their positions through business planning and contingency strategies, and offers alternative financing avenues for applicants whose loans are rejected, including venture capital, peer-to-peer lending, and government-backed soft loans.
Applying for a loan at a bank or any financial institution with lending capabilities can be frustrating, especially if the applicant does not know exactly what they are supposed to do to win the loan officer's confidence. Banks have an obligation to protect the funds and assets that clients have entrusted to them; as such, they often are very conservative. At the same time, they also are in business, out to make profit by recouping the principal of loans that they extend to borrowers, obtaining a profitable rate of return on the same, and ensuring that borrowers prosper and increase their deposits with them. In the final analysis, it is the borrower's responsibility to develop and maintain positive relations with the bank and provide sufficient reason for the bank to feel safe entrusting their capital to them.
This text is, in basic terms, a guide to business owners as to what exactly needs to be done to get bankers to approve their applications. It outlines the various factors that bankers consider before approving or rejecting a loan application, and the fundamental measures that borrowers could take to get their loan applications approved.
Regardless of the type of loan being applied for, bankers will often consider the following four factors in determining whether or not to give approval: credit history, availability of collateral, the business' history of cash flows, and the debt-to-net-worth ratio. Understanding each of these criteria—and how lenders evaluate them—is essential for any borrower seeking to strengthen their application.
Loan officers will often review a borrower's personal credit history as well as that of their business (if it is not a start-up) to determine their degree of creditworthiness (Abraham & Zhang, 2008). For a business that has been in existence, lenders will often consider a business creditworthy if it has at least five trade experiences. The applicant's personal credit history can be obtained from consumer credit reporting agencies; it is an outward representation of an individual's character in terms of honoring their debts.
Towards this end, business persons who have been running their business with personal assets alone and no credit could boost the chances of their entities being considered creditworthy by making a number of trade credit purchases before making their loan application. This proactive approach demonstrates to lenders that the business has an established pattern of managing debt responsibly.
Collateral is some kind of security that a borrower offers the bank or lender to obtain credit; if the borrower defaults, the lender may seize the property put forth as collateral to recover the principal amount (Abraham & Zhang, 2008). Collateral is one of the crucial requirements for obtaining credit and is meant to minimize the risk associated with extending the same.
Collateral will often be required to match the loan being extended, and its useful life has to either meet or exceed the term of the loan. Most lenders will require that property put forth as collateral not have any prior or superior liens. This is their way of ensuring that they have a priority claim over the property in case of default. Without such assurance, lenders face unnecessary risk.
A lender will often review a business' cash-flow cycle—the average period between the time inventory is purchased and when it is sold, or when accounts receivable are collected—to determine whether the business' daily operations are capable of supporting the loan being sought. That is, the lender wants to know whether enough money is being generated on a daily basis to help repay the loan. Besides money generated from sales less everyday expenses, a business' cash flows will also include proceeds from financial or investment activities such as leases, purchase of machinery, insurance, contracts, and so on.
A business will be deemed creditworthy if its ongoing collections and sales represent a regular and sufficient stream of cash (Abraham & Zhang, 2008). A business owner can boost their chances of obtaining credit by improving their cash flow position through delaying their debt payments, collecting receivables as soon as possible, accelerating cash receipts and reducing credit allowances, or reviewing relevant tax strategies. For instance, availing accelerated depreciation can increase the business' short-term deductions (Abraham & Zhang, 2008).
The debt-to-net-worth ratio measures the degree to which a business is supported by debt. A high debt-to-net-worth ratio indicates that the entity is supported to an unhealthy degree by debt (highly leveraged) (Bangs, 2010). Entities with high debt-to-net-worth ratios are taken to be less creditworthy and are hence less likely to receive credit than those with lower ratios.
This is particularly because net worth represents the amount of owner's equity invested in the business; the higher it is, the higher the business owner's stakes, the more committed he is likely to be to the business' success, and the higher the likelihood that the business is a going concern. Lenders view owner investment as a signal of commitment and confidence in the business itself.
In summary, bankers will often turn down a loan application if there is insufficient owner's equity and consequently a considerably high debt-to-net-worth ratio, the business for which the loan is being sought displays a record of poor earnings, the property offered as collateral is of low quality and does not guarantee a priority claim, or the business owner has a tarnished past in terms of debt repayment.
Business owners could increase their chances of obtaining credit by drawing up a comprehensive business plan and developing a contingency plan (Bangs, 2010). A business plan is intended to make the banker feel safe lending out their capital to an individual seeking to borrow money. It shows, among other things, the amount of loan you need (as the borrower), why and when you need it, and your planned repayment plan. It also adds credibility to your business through income statements, projected cash flow statements, and balance sheets (Bangs, 2010). This gives the banker some kind of assurance that you have a plan or proposal in mind, a proposal that if successful could see you return to expand the bank's business by opening up more accounts.
Further, a business owner ought to have a contingency plan, "a short worst-case business plan that examines the options that would be open to the business and how those options would be treated" (Bangs, 2010, n.pag). It not only shows that the business person has looked ahead, but also gives the banker some form of assurance that the borrower anticipates business cycles and has put in place measures to address the same effectively when they occur.
We cannot overlook the possibility of a business owner's loan application being rejected; in fact, a significant number of loan applications today never sail through, particularly because banks are increasingly tightening their credit regulations so as to avoid a repeat of the factors that led to the 2008 financial crisis. The very first thing to do when your loan application is rejected is to try and find out from the banker the specific reasons for rejection. Once these are clear, then you can pursue other avenues of obtaining the finances being sought (Bartram, 2014).
These alternatives could include borrowing from friends and family, seeking venture capital, borrowing from business angels, considering asset-based financing, invoice discounting, taking up leasing options as opposed to buying in a bid to increase cash flows, seeking out concessional funding (soft loans) from relevant government agencies, and raising funds online through peer-to-peer lending clubs such as Thincats.com and Funding Circle, which bring together borrowers and prospective lenders (Bartram, 2014). Exploring these alternatives can provide the capital needed when traditional bank financing is unavailable.
Bank loans are among the most common sources of finance for both start-up and established business entities. However, owing to the effects of the 2007 financial crisis, banks have tightened their lending policies; and this only implies that chances of one's loan application getting rejected are rather high. Banks will consider a borrower's character, credit history, the business' cash-flow cycle and degree of leverage, and the availability of collateral when deciding whether or not to extend credit.
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